Is an All-Time Market High Justified?

Did you know that on January 19th, the Russell Small Cap Index was within 6 percentage points of its all-time high of 855?

Surprised? I would think so. Given the severity of the recent recession it seems that stocks have defied gravity to roar back to such lofty levels. Take a look at the five year chart below and you'll see what this rally looks like in a historical perspective.

A quick look at this chart, and the perspective that small cap stocks were so close to breaking out to an all time high, might make you think that stocks are wildly overvalued. The market certainly thinks so, as small caps have fallen 4.3 percent over the last three sessions.

In fact in some cases stocks are wildly overvalued, and to be perfectly honest I wouldn't rush out to buy an ETF right now that tracks any of the major indices. Chances are this will be dead money, and the risk-return potential doesn't justify that type of investment right now.

But I don't think you need to stay away from all small cap stocks simply because the Russell Small Cap index is less than 10 percent away from its all time highs. There is always value to be found in the market - if you look hard enough.

The trick is to not push too hard. If you can't find value, don't do anything. The best investment you might make is no investment at all. But that doesn't mean the time you spend researching stocks without a purchase resulting is wasted time.

Take notes on your research, pick the stocks you want to buy, the price you think they are attractive at, and wait for your opportunity.

In last Thursday's letter, I wrote that investors should take the market's recent action as a message that they should re-balance their portfolios. For active investors, this may be less important since they tend to watch their portfolios closely on almost a daily basis. But for anyone who hasn't checked in on their holdings recently, now is a good time to do so.

Why? As I wrote on Thursday:

My outlook is that individual stocks will decouple from the major indices and will start to move on more stock and industry specific news. I believe that the broad market will become increasingly volatile as this decoupling happens, and that index investors will not see much difference in the value of their holdings.

I think this decoupling will go on for the next few months, so there is no huge rush to try and re-balance your portfolio all at once. A couple of tips to help you get started:

Sell out of the positions you don't have conviction in for the next 6 to 12 months. You can use this cash to buy shares of stocks you have more confidence in.

Consider taking profits on some of your positions, if you have profits to take. This doesn’t mean selling all of your shares. Depending on your conviction in the position, think about selling around 50 percent of your shares.

Do your research and be ready to buy more shares of the stocks you want to hold for the next 6 to 12 months. If you did the above, you should have capital available to use without having to take this out of savings, or waiting to generate it through your normal income streams.

Average into the positions you decided you want to own for the next 6-12 months. This could mean adding to positions you already have and want to continue to own, or starting positions in new investments. Consider buying in two to four tranches to average out your cost basis.

Doing the above will help you mitigate the risk of buying too many shares when the broad market gets stretched.

But the strategies will also help you stay in the market to take advantage of the inevitability that many stocks will continue to rise. After all, if you're not in the market, you have no chance of making any profits at all.

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